(Adds comment from Illinois Senate president)
By Karen Pierog
CHICAGO, Nov 21 (Reuters) - A judge ruled on Friday that an Illinois law aimed at easing the state's huge unfunded pension liability is unconstitutional, handing a victory to labor unions and state retirees who challenged the law and an initial defeat to the state's efforts to fix its sagging finances.
The judge's sweeping ruling will send the case to the Illinois Supreme Court for a final determination on the law's constitutionality. The Illinois Attorney General's Office, which is defending the law, said it will ask the high court for an expedited appeal.
Sangamon County Circuit Court Judge John Belz, who ruled a day after hearing oral arguments on the state's pension reform law, found that the law both diminishes and impairs retirement benefits for public sector workers in violation of a state constitution provision. The judge rejected the state's argument that public workers and retirees have a contract for pensions that can be modified to protect the public welfare in the case of an emergency, and that Illinois' dire financial situation constitutes an emergency.
"In summary, the state of Illinois made a constitutionally protected promise to its employees concerning their pension benefits," Belz's ruling stated. "Under established and uncontroverted Illinois law, the state of Illinois cannot break this promise."
Illinois has the worst-funded state retirement system, and its huge unfunded pension liability has helped pound its credit ratings to the lowest level among states. The unfunded liability for Illinois' five state retirement systems hit $104.6 billion at the end of fiscal 2014.
Republican Governor-elect Bruce Rauner, who will inherit the pension problem when he takes office in January, said in a statement he will work with the Democratic-controlled legislature "to craft and implement effective, bipartisan pension reform."
Belz's ruling leaned heavily on a July Illinois Supreme Court decision in an unrelated case that concluded healthcare for retired state workers was a pension benefit protected by the constitution. In that case, the court ruled the wording of Illinois' constitution makes it "plain" and "unambiguous" that the pension protections cannot be reduced, Belz noted.
"I have always been extremely skeptical of the constitutionality of (the law)," said Illinois Senate President John Cullerton, adding that his union-backed bill, which gives workers something in return for pension cuts and which was passed by his chamber but not the House, remained a viable constitutional backup for the state.
Ted Hampton, an analyst at Moody's Investors Services, said the ruling is a negative development, but the state's A3 rating already assumed the reforms would not be implemented.
Belz's ruling, if upheld by the state supreme court, could have broader implications. It calls into question the viability of a state law enacted in June to tame Chicago's huge pension burden, and is a sign that other Illinois municipalities will not soon receive pension relief.
When Moody's cut Chicago's rating to Baa1 from A3 in March due to the city's "massive and growing" unfunded pension liabilities, the rating agency said Chicago could be hit with another downgrade if Illinois' reforms are ruled to be unconstitutional and if the city fails to match revenue to required pension contributions.
Arizona and New York have pension protections in their constitutions that are similar to Illinois' and have also had court rulings that prevented pension cuts, according to Stuart Buck, an analyst who has tracked pension funding litigation at the Laura and John Arnold Foundation.
The reform law was enacted in December 2013 to help save Illinois' sinking finances. It reduces and suspends cost-of-living increases for pensions, raises retirement ages and limits salaries on which pensions are based. Employees contribute 1 percent less of their salaries toward pensions, while contributions from the state, which has skipped or skimped on its pension payments over the years, are enforceable through the Illinois Supreme Court.
Although the law was slated to take effect on June 1, Belz put it on hold in May, until five lawsuits consolidated in his courtroom are resolved, first by him and ultimately by the state's high court. (Editing by David Greising and Matthew Lewis)